How To Invest in a Bond

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Published: June 2, 2011 2:08 p.m. ET

Last Updated: June 2, 2011 3:53 p.m. ET

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Bonds are touted for their minimal risk and frequent interest payments, but you still have to be careful.

Investors tend to view bonds as the safe portion of their portfolio. And while bonds are usually less volatile than stocks, they aren't foolproof. Like many other investments, bonds also require investors to take greater risk for greater returns.

Most individual bonds are bought and sold in an over the counter market, which you can access through an investment adviser or directly through a broker. There are a handful of bonds that trade on an exchange.

One key thing to understand about bonds: price and yield have an inverse relationship. Price is the amount you pay for the bond. Yield, or current yield, refers to the dollar amount the bond pays monthly, quarterly or semi-annually, as a percent of the price you paid for the bond. Yields fall as prices move higher and vice versa. (More on that here.) Another stat to watch is yield-to-maturity, this is a figure that incorporates both interest payments as well as the return of principal, relative to the price paid for the bond.

Here are some tips for choosing the right bond.

Research the options. Do you need steady reliable income or are you willing to take some volatility in exchange for higher payouts?

Treasury bonds provide steady payments. Because they are backed by the federal government, Treasury bonds have little risk of default. But that safety also means yields are going to be lower than those of riskier bonds, such as corporate bonds.

Take more risk if you need higher yields. Investment- grade corporate bonds, those issued by companies rated BBB/Baa or higher from bond rating firms like Moody's, Fitch Ratings or Standard & Poor's, pay more than Treasurys because they have a slightly higher risk of default. Even riskier high-yield or "junk" bonds, rated below BBB, have higher yields still -- and have an even higher risk the issuing company will default on its payments.

Use municipal bonds for tax-free income. Investors in higher tax brackets often benefit from investing in municipal bonds, because their interest payments are exempt from federal taxes and sometimes from state taxes. Yields on "munis" tend to be lower than comparable Treasurys, but, on a tax-effective basis, munis yield the same or more than comparable Treasurys.

Know the risks. You can still lose money with bonds, but some are riskier than others.

Consider credit risk. Lower-rated bonds offer higher yields but they also have a greater risk of default. Keep this in mind before reaching for high yield.

Low credit risk doesn't mean risk free. Certain bonds, like Treasurys, have almost zero default risk. But they are very vulnerable to interest rate risk, meaning prices will take a nose dive if interest rates shoot up, which is important if you want to sell the bond on the secondary market. Higher inflation can also erode the spending power of a bond's fixed payments.

Watch price movements. Some bonds sell at a premium to par value, the amount the investor gets back in principal when the bond matures. This open happens when interest rates for similar issues are now lower than the rate on the bond you are considering. Some bonds, however, can be redeemed early (known as "called back") and investors who take that risk can find themselves getting a lower rate of return than anticipated and are unable to recoup that premium they paid.

Choose between bond funds and bonds. Once you know what you want to get out of your bond portfolio, you need to determine the most cost efficient way of making it happen.

Use bond funds to spread your bets. If you have less than $200,000 to invest in bonds and want to own several different bonds or types of bonds, it may be easier to diversify through bond mutual funds, which have lower minimum investments compared to buying bonds outright. They can also be far easier to sell, if you need the money for something else. That's not to say you can't pull off an individual bond portfolio with fewer assets -- you may just have to sacrifice some diversification.

Buy individual bonds for more control. If you have enough assets, you can create your own bond portfolio by buying individual bonds across various classes. Holding individual bonds also reduces interest-rate risk by giving investors the option to hold bonds to maturity so they can get their principal payments in full. Some financial advisers recommend what's called laddering -- buying bonds with different maturities to hedge against interest rate changes.

What not to do when considering a bond or bonds to buy.

Don't aim just for yield. When interest rates are low, some investors may be willing to take on more risk in exchange for higher payouts. But putting too much money into a single bond issuer or bond type—say allocating too much money to high yield bonds or Treasury bonds-- can lead to large losses.

Don't neglect credit ratings. Bonds can get downgraded when economic conditions change. Don't assume that AAA-rated bond you bought years ago still has that high rating today. Check credit rating agencies such as Standard & Poor's, Moody's Investors Service and Fitch Ratings for news of downgrades or upgrades to bond issuers.

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